For more than a year and a half now, the UK economy has defied fears of the Brexit vote causing a recession. But the worries haven’t stopped — instead they have morphed. The latest iteration, seen throughout the financial media, warns that the UK is entering a Japanese-style ‘lost decade’ where firms hoard cash, invest little and rely on currency translation for profits. So far, however, we see little evidence that this is happening. Rather, we believe the latest fear is evidence that feelings towards the UK economy remain overly sceptical, increasing the likelihood that reality will continue beating expectations — a potential tailwind for UK shares.
The new fear du jour, summed up in a recent Wall Street Journal article, goes like this: although UK corporate earnings have risen since the Brexit referendum, currency weakness is the key driver, benefitting multinationals the most. And instead of taking advantage of weak sterling to cut export prices and gain market share, firms have done what Japanese companies did, keeping end-market prices steady and booking the gains from currency translation as profit.
Adherents of this theory cite as evidence rising corporate cash balances and spotty business investment. Yet, while it may be fair to credit sterling weakness for some of multinationals’ earnings growth, in our view, export data indicates that the broader narrative about companies living off currency conversion alone almost certainly isn’t true.
As Exhibit 1 shows, after Japan’s yen began weakening significantly in late 2012, exports started recovering when measured in values — which reflect currency translation — but continued falling for several months when measured in volume terms, which omit currency skew. Even when export volumes began growing in mid-2013, they remained choppy and badly lagged behind export values. We believe this is strong evidence that Japanese exporters were indeed living off the currency gains rather than seizing the opportunity to cut prices and raise production.
Exhibit 1: Japanese Exports and the Yen
[caption id="attachment_10423462" align="alignnone" width="620"]
Source: FactSet, as of 15/2/2018. Year-over-year growth rate in Japanese goods export values and volumes and JPY/USD spot rate, January 2011 – December 2017.[/caption]
In the UK, however, export volumes have been much stronger. Although most people cite the pound’s plunge immediately after the referendum, sterling actually began weakening against the dollar in mid-2014, lengthening the available dataset. For much of the next two years, goods export volumes were nicely positive, whilst export values frequently tumbled. Export values began recovering in July 2016, whilst export volumes endured a short rough stretch, before resuming growth in 2017. Throughout the year, even though values grew faster, volume growth remained strong — much stronger than in Japan in 2013 and 2014. And what’s equally noteworthy is that export volumes remained positive for much of the global trade slump that ran from late 2014 to early 2016, demonstrating UK plc’s resilience.
Exhibit 2: UK Exports and the Pound
[caption id="attachment_10423492" align="alignnone" width="620"]
Source: FactSet and Office for National Statistics, as of 15/2/2018. Year-over-year growth rate in UK goods export values and volumes and GBP/USD spot rate, January 2011 – December 2017.[/caption]
Moreover, claiming that UK firms are hoarding cash and not investing ignores global trends — making this, in our view, a myopic claim. UK corporations aren’t unique in building cash buffers, and the practice predates Brexit. Companies throughout the developed world have also been amassing large cash stockpiles. Exhibit 3 shows aggregate cash on hand at all private non-financial corporate businesses in the UK, the eurozone, Japan and US, indexed to 1999, when eurozone data begin. Oddly, Japanese cash balances have grown the least, while the US, UK and eurozone’s have all more than trebled. And note the acceleration after the global financial crisis (circled). This makes sense when you remember the trauma wrought by the panic. As liquidity froze worldwide, companies learned first-hand the value of having large cash buffers to insulate against a funding freeze and to see them through lean times.
Exhibit 3: Cash on Corporate Balance Sheets
[caption id="attachment_10423552" align="alignnone" width="620"]
Source: UK ONS, ECB, Japan Finance Ministry and US Federal Reserve, as of 15/2/2018. UK, eurozone and Japanese figures include all currency and deposits. US figure includes all liquid assets. Q1 1999 – Q3 2017.[/caption]
Even so, rising corporate cash balances don’t appear to have stalled investment. Exhibit 4 shows UK corporate cash balances and business investment since this economic expansion began in Q3 2009. Cash piles have grown at a fairly steady rate since Q1 2012, whilst business investment has been more variable — but has actually grown at a steadier pace since the Brexit referendum. Growth rates aren’t huge, but this stems largely from cutbacks in the North Sea oil industry — a symptom of the industry’s efforts to battle a global supply glut and defend against lower oil prices, not of Brexit-induced weakness. US business investment experienced a similar phenomenon, though it enjoyed more of a rebound last year due to lower extraction costs and shorter lead times in onshore shale formations relative to the expensive offshore drilling in the North Sea. We have no way to know if UK business investment would have been higher or lower without Brexit, as there is no counterfactual. But it certainly isn’t tanking.
Exhibit 4: UK Corporate Cash Balances and Business Investment Growth
[caption id="attachment_10423482" align="alignnone" width="620"]
Source: UK ONS, as of 15/2/2018. Private nonfinancial corporations’ total currency and deposits and q/q percentage change in quarterly business investment, Q3 2009 – Q3 2017.[/caption]
In our view, the theory about firms simply hoarding currency-related profits contains one additional error: it ignores the many other drivers of earnings for UK firms. Materials and energy firms, which feature prominently in the FTSE 100, are vulnerable to metals, oil and other commodity prices. Both of these sectors’ profits are price-sensitive, not volume-sensitive, and commodity prices have broadly struggled for years. Financials firms — particularly banks — rely on interest rate spreads to drive much of their earnings, as the difference between long and short rates determines net interest margins, which drive lending profits. Even large industrials, consumer discretionary and other export-heavy sectors don’t benefit universally from currency conversions when the pound is weak. After all, most exporters import components, natural resources and even labour. A weaker pound raises these costs, which can offset many of the benefits of currency translation.
It wouldn’t surprise us if Brexit-related economic fears continued morphing over the foreseeable future —feelings normally take a long time to change. In our regular analysis of financial media over the years, we saw eurozone fears morph often during the debt crisis and its aftermath. We also observed fears of a Chinese economic hard landing in multiple guises since 2011. We believe this phenomenon has a silver lining for equity markets: it allows them to price in all manner of worries, creating possibly more room for positive surprise if reality doesn’t go as badly as feared.
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